3 Utilities That Income Investors Should Be Watching

Water utility companies, or businesses responsible for providing water and sewer services to residential and commercial customers, appear to be an attractive choice for investors searching for income. Product demand is secure, competition is limited, and pricing is set by regulation -- an environment well suited to provide steady and ample dividends. But some water utilities, like American Water Works (NYSE: AWK) , California Water Service Group (NYSE: CWT) , and American States Water (NYSE: AWR) may also offer shareholders noticeable capital gains. How can these companies offer income and potential price appreciation?

Water and sewer systems need repairThe water-service industry could be in for some plentiful growth. Water and sewer infrastructure investment is desperately needed. Much of the U.S. water pipeline system is in need of repair. Reports indicate that a major water main breaks about every two minutes. The nation's sewer systems could be in worse shape. Of the nations' estimated 800,000 miles of sewer mains, almost half could be classified as poor or life elapsed by 2020. Water companies, which typically get nicely compensated for any capital improvements they make, should be major beneficiaries from the required repair work.

A large and aggressive beneficiaryOne company likely to profit is American Water Works. The largest publicly traded U.S. water and sewer utility, it aims to produce 7% to 10% long-term earnings growth. This aggressive utility's latest quarter was slightly disappointing. Income from continuing operations was down around 2% year over year, mainly due to unfavorable weather reducing demand. While water sales were down around 1%, American Water's total company sales were basically flat thanks to a compelling growth avenue, homeowner services.

American Water offers domestic homeowners and small companies protection service for damaged or blocked pipes inside and outside their locations. This business has become very popular. Revenue in the latest quarter rose 5% year over year and looks to continue growing. Recently expanding into Florida and Washington, D.C., homeowner services has added more than 250,000 new customers so far this year.

American Water currently offers a dividend yield of around 2.6% and looks fairly valued at around 14 times cash earnings. Though slightly higher than its average 12x multiple over the last couple of years, the pricing seems reasonable given the industry's outlook and the company's projected earnings growth.

Regulatory decisions matterCalifornia Water Service is a smaller, less active water utility but also has growth potential. In its latest quarter, the utility posted a revenue gain of around 3.5% with net income down slightly from the prior year. The profit falloff was mainly due to higher purchasing costs and increased expenses from infrastructure improvements put into service. The sales gain came from approved rate increases.

Utilities need regulatory-body approval for rate changes. Regulators typically allow companies to recover their costs and gain a reasonable rate of return. California Water is in a desirable market. Most of the company's more than 500,000 customers reside in California with about half located in the Los Angeles and San Francisco areas. The company is therefore reliant on the California Public Utilities Commission's rulings for its results.

One regulatory difficulty is the time lag between submitting a rate increase and its approval. California Water reached a regulatory settlement over its 2012 rate submission only in October. The agreement, which will provide additional revenue of $45 million in 2014, $10 million in 2015 and 2016, and up to $19 million upon completion of certain infrastructure projects, won't be officially sanctioned until early 2014.

California Water Service, delivering around a 2.8% dividend yield, appears to be richly priced at around 19 times cash earnings. That figure might be deceiving, however. A more accurate valuation may be enterprise value (stock market capitalization plus debt) relative to sales, given the regulatory lag in reported results versus what assets are really earning. California Water's enterprise value of roughly 2.8 times sales, noticeably lower than American Water's enterprise value/sales ratio of around 4.5, looks more reasonable.

Providing water to the militaryAmerican States Water is another California-based water company. It provides service to approximately 256,000 customers located in Northern, Coastal, and Southern California. The company is doing well, reporting a year-over-year 11% net income increase in its recent quarter. The gain was helped by its water business, where revenue increased 3.2% due to regulatory-approved higher water rates.

As good as the water operations were, equally exciting is the company's non-regulated contract business. Providing water systems operating services to military bases throughout the country, American States typically derives secured profits on these long-term contracts. Additional revenue can also be obtained from new construction activity. Though, as construction activity varies, results can be inconsistent. Recent quarterly contract revenue dropped about 18% due to reduced construction at two military locations. The company is looking to add business, however. It received $18.5 million in new construction project orders in the last quarter.

American States appears fairly priced at around 18 times cash earnings and an enterprise value of roughly 2.8 times revenue. With a dividend yield of near 2.9%, this water provider could have possible upside from its military-contract opportunities.

Bottom lineWater utilities might have what income investors are looking for and more. These businesses offer a generally safe dividend and potential capital gains, thanks to the growing need for water-infrastructure renewal, and investors may want to consider companies such as American Water Works, California Water Service, or American States Water for their income portfolios.

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